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section header ETF fundamentals

subsection header Strategies

Active/passive combinations

Actively managed investments offer an opportunity for outperformance, but they also bring greater relative risk and unpredictability.

Low-cost passively managed investments typically reflect the risk and return characteristics of a given market segment but do not offer the opportunity for outperformance. Combining low-cost active funds and ETFs with index-based ETFs can achieve a balance between the two approaches.

 

Core-satellite approach

One way to do this is with a "core-satellite" strategy that employs indexing at the core of a portfolio and actively managed funds as satellites. This idea recognizes the differences between indexing and active management and combines the best aspects of both approaches.

The index core provides a risk-controlled, low-cost way to capture market returns (beta) over the long-term, while the actively managed satellites provide an opportunity for market outperformance (alpha).

Active approach Index approach
  • Seeks to outperform
  • Higher costs
  • Higher manager risk
  • Shorter-term focus
  • Lower potential tax efficiency
  • Seeks market return
  • Lower costs
  • Lower manager risk
  • Long-term focus
  • Higher potential tax efficiency

 

Core-satellite methodology

The conventional view of core-satellite methodology (Figure 1) suggests that it’s prudent to use index funds for markets that are deemed efficient, such as large-cap stocks. This view holds that actively managed funds make more sense to use in areas of the market that are considered to be inefficient, such as small-cap or emerging market stocks. The thinking here is that active managers are more likely to succeed in these areas.

 

Figure 1

Source: Vanguard. This hypothetical investment or portfolio strategy is shown for illustrative purposes only and shall not be construed as a recommendation to buy or sell any security or financial instrument, or an offer or recommendation to participate in any particular trading or investment strategy.

An alternative view of core-satellite investing (Figure 2) suggests that indexing is a powerful investment strategy in all market segments. As a result, the active/index decision should be predicated on an investor’s ability to identify low-cost, talented managers, not on the indiscriminate selection of active managers in apparently inefficient market areas. This view holds that skill in selecting active managers drives the success of a core-satellite portfolio.

 

Figure 2

Illustration showing broad international bond and stock market index ETFs at the core of a portfolio with three different active manager products as satellites.

Source: Vanguard. This hypothetical investment or portfolio strategy is shown for illustrative purposes only and shall not be construed as a recommendation to buy or sell any security or financial instrument, or an offer or recommendation to participate in any particular trading or investment strategy.

 

Points to consider

  • There is no guarantee that a combined active/passive approach will be less risky than an all-active or all-index approach and will achieve comparable returns.
  • Whether they choose active or passive funds, investors should consider funds that have low overall costs to increase the probability of long-term success. Costs directly detract from investment returns.
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Basics

Learn the basics of ETFs, including their history, how they compare to mutual funds, what types are available and more.

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Indexing

Learn about the advantages of indexing, how ETFs are indexed, the differences between excess return and tracking error, and more.

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Trading

Learn how ETFs trade, where they get liquidity, common order types, how premiums and discounts work and more.

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